My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Tuesday, September 30, 2014

The Walking Dead: Blackberry, Yahoo and the Zombie Apocalypse!

I will start with a confession. I have distinctly lowbrow tastes when it comes to literature, movies and entertainment. I would much rather read a novel about a unhinged serial killer than one written by the latest Nobel Literature Prizewinner, watch The Avengers than an art film and be at Yankee stadium than the Museum of Modern Art. That may reflect the limits of my intellect and the shortcomings of my cultural education, but I know what I like, am set in my ways and no cultural gatekeeper is going to tell me otherwise. Given my plebeian tastes, it should come as no surprise that last summer, I joined my fifteen-year old son in binge-watching the first three seasons of The Walking Dead, a television show with not much of a stray line, lots of gore and few redeeming social qualities. For those of
you who have never watched the show, here is a taste:

You may be wondering why I am talking about television shows
on a blog dedicated to markets, but the Walking Dead was what came to my mind in the last couple of weeks, as I watched Blackberry and Yahoo, two companies that I have posted about before, make the news. Blackberry announced that they were introducing a new phone, priced at $599, and aimed at getting them back into the smartphone
market. Yahoo was initially not in the news, but Alibaba, a company that Yahoo owns 22.1% of, was definitely the center of attention at its initial public
offering on September 19. While Alibaba opened to rapturous response, its stock
price jumping 38% on the offering date, Yahoo’s stock price strangely dropped by 5%, the day after. By the end of last week, Yahoo had been targeted by an activist investor, taken to task for not managing its Alibaba tax liability and pushed to merge with AOL. Since I have owned Yahoo for the last few months, I have a personal financial interest in trying to make sense of the dissonant behavior and I am afraid that the Walking Dead is the best I can come up with as an explanation.

The Life Cycle and beyond

A few months ago, I posted on the life cycle that businesses
go through and argued that companies are born, grow, mature and decline and
that it is often both expensive and pointless to fight the cycle.

The life cycle view of the corporate world may be simplistic, but it is surprisingly powerful in analyzing the evolution of corporate governance and different investment philosophies. Thus, there are some who argue that while an autocratic CEO can be a hindrance in a mature or declining company, he or she can be an asset early in the life cycle, and that success goes to those who are strong on narrative, early in the life cycle, but that the numbers people dominate later.

In a series of posts, I looked at the challenges of managing and investing in companies across the life cycle, including a few in the most depressing phase, which is during decline. I also conceded that there are examples of rebirth and reincarnation, where
companies find a way back from decline (IBM in 1992 and Apple in 1999). In most
cases, though, companies in decline that try to spend their way back to
maturity have little to show in terms of earnings and growth for the billions
of dollars spent on investments, acquisitions and R&D.

The Walking Dead Company

In drawing a parallel between human beings and
corporations on the life cycle, I think I missed a key difference. Human beings die, no matter how heroic the medical
attempts to keep them alive may be. Corporations on the other
hand can survive well after their business models have expired, the Walking
Dead of the business world, and can
create damage to those vested in and closest to them. Here are the characteristics of these zombie companies:

Broken Business Model: The company's business model is dead, with the causes varying from company to company: management ineptitude, superb competition, macroeconomic shocks or just plain bad luck. Whatever the reasons, there is little hope of a turnaround and even less of a comeback. The manifestations are there for all to see: sharply shrinking revenues, declining margins and repeated failures at new business ventures/products/investments.

Management in Denial: The managers of the company, though, act as if they can turn the ship around, throwing good money after bad, introducing new products and services and claiming to have found the fountain of youth. In some cases, the company may change managers at frequent intervals during the death spiral, but they all share in the denial.

Enabling Ecosystem: The managers are aided and enabled by consultants (who collect fees from selling their rejuvenating tonics), bankers (who make money off desperation ploys) and journalists (either out of ignorance or because there is nothing better to write about than a company thrashing around for a solution).

Resources to waste: While almost all declining companies share the three characteristics listed above, the walking dead companies are set apart by the fact that they have access to the resources to continue on their path to nowhere and have to be kept alive for legal, regulatory or tax reasons. Those resources can take the form of cash on hand, lifelines from governments and/or capital markets that have taken leave of their senses.

The challenges that you face as an investor in a walking dead company is that you cannot assess its value, based upon the assumption that the managers in the company will take rational actions: make good investments, finance them with the right mix of debt and equity and return unneeded cash to stockholders. To get realistic assessments of value, you have to assume that managers will sometimes take perverse actions, investing in low-probability, high-possible-payoff investments (think lottery tickets), financing them with odd mixes of debt and equity (if you are on the road to nowhere, you don't particularly care about who you take down with you) and holding back cash from stockholders. Incorporating these actions into your valuation will yield lower values for these companies, with the extent of the discount depending upon the separation of management from ownership (it is easier to be destructive with other people's money), the capacity of managers to destroy value (which will depend on the cash/capital that they have access to and will increase with the size of the company) and the checks put on managers (by covenants, restrictions and activist investors). At the limit, managers without any checks, given enough time, on their destructive impulses can destroy all of a company's value, if not immediately, at least over time. For value investors, these companies are often value traps, looking cheap on almost every value investing measure but never delivering the promised returns, as managers undercut their plans at every step.

Blackberry’s future:
Staring into the Abyss

In fact, I argued in a post in December 2011 that
Blackberry (then called Research in Motion) needed to act its age, accept that
it would never be a serious mass-market competitor in the smart phone market
and settle for being a niche player. That post, which occurred when Blackberry
had a market capitalization of $7.3 billion, argued that Blackberry should give up on
introducing new tablets or phones and revert to a single model (which I termed
the Blackberry Boring) catering to paranoid corporates (who do not want their
employees accessing Facebook or playing games on smart phones). I also
suggested that Blackberry settle on a five-year liquidation plan to return cash
to stockholders.

I was accused of being morbid and overly pessimistic, but here we are
three years later, with Blackberry’s market cap at $5.3 billion. In the three years since my last post, the company has spent $4.3 billion in R&D, while its annual revenues have dropped from $18.4 billion in 2011-12 to $4.1 billion in the last twelve months and its operating income of $1.85 billion in 2011-12 has become an operating loss of -2.7 billion in the trailing twelve months. Blackberry’s new model may be a technological marvel, but the smart phone market has moved on, where a phone is only as powerful
as the ecosystem of apps and other accessories available for it is. If it was true three
years ago that Blackberry could not compete against Apple and Google in the
operating system world, it is even truer today, when either of these mammoth
companies can use petty cash to buy Blackberry. (Apple’s cash balance is $163 billion,
Google’s cash balance is $63 billion and Blackberry’s enterprise value is $4.1 billion).
Perhaps, I am missing something here, but I really don't see any light in the smartphone tunnel for Blackberry and even if I do, it is the headlight of an oncoming locomotive.

The options for Blackberry, in my view, are even fewer than
they were three years ago. At this stage, I am not sure that even the niche market option is viable any more. I see only two ways to
encash whatever value is left in the company. The first is to hope that a
strategic buyer (which to me is a synonym for someone who will pay far more
than justified by the cash flows) with deep pockets will see some value in the
Blackberry technology and buy the company.The second is a more radical idea. In a world where social media
companies like Facebook, Twitter and Linkedin command immense value, with each
user generating about $100 in incremental market cap, Blackberry should
consider relabeling itself as a social media company, create a Blackberry Club,
where those with Blackberry thumbs can stay connected. Outlandish, I know, but why not?

Note that these numbers reflect my estimates of intrinsic value, which generated $146 billion for Alibaba's equity. I then revalued it on a relative basis at $39.19, but this valuation reflected a pricing of Alibaba at $118 billion.

I closed by arguing that the stock seemed under priced at
$ 34 and that I would use it as my proxy bet on Alibaba. The stock initially stalled but as the Alibaba
IPO became imminent, Yahoo’s stock price rose to $42.09 at close of trading on Thursday, the day before the IPO:

Alibaba went
public on Friday, September 19, and its market capitalization jumped to $230 billion. I updated my valuations and prices of Yahoo, Yahoo Japan and Alibaba in the table below:

Updated using trailing 12-month values

Note that both the intrinsic and relative values of Yahoo have increased over the period, almost entirely due to an increase in Alibaba's intrinsic value. It is true that Yahoo did have to sell 124 million shares (actually good news, since that amounted to only 5.1% of Alibaba shares, when initial estimates suggested that the would have to sell about 9%) worth of Alibaba stock on the IPO date at the IPO price of $68, giving it a net cash balance of about $ 8 billion on Monday, after allowing for a tax liability of $3.3 billion on the Alibaba stock sale. Updating the intrinsic value picture to reflect this, here is what I get:

Allowing for both the higher cash balance and the re-estimated intrinsic values for the three businesses, my estimate of intrinsic value of $46.44 per share for Yahoo is higher than the current price of $40.66. If you don't trust my intrinsic value estimates, here is a simpler and far more powerful picture of where Yahoo stands today. Using today's market prices for Yahoo's holdings in Alibaba and Yahoo! Japan and adding the net cash balance that Yahoo has, net of taxes due on the shares sold on the IPO date, the value per share is $52.14. At its current price, the market is attaching a value of -$12.22 billion (-$11.48/share) for the operating assets in Yahoo US.

It is tough to imagine that this is a market oversight, since the market values of Yahoo Japan and Alibaba are easily checked and the cash balance is not really subject to debate. I am more inclined to view this as a Walking Dead discount, reflecting investor concerns, merited on not, that Yahoo's management might do something senseless with the cash, and incorporating the reality that liquidation is not a viable or a sensible option today. Why? Liquidating Yahoo's holdings today will require cashing out of the Yahoo Japan and Alibaba holdings today, resulting in a total tax bill of $16.3 billion and a value for the equity per share of $34.18.

What now?

As an investor in Yahoo, the question I face is whether the discount that the market is applying to Yahoo is reasonable. While I believe that Marissa Mayer can do serious damage to me as investor, by embarking on ambitious expansion plans with the cash, I also believe that she will be checked by activist investors along the way. I will continue to hold Yahoo, at least at its current price, and hope for the best. That, to me, would require that Ms. Mayer recognize that Yahoo is really a shell company with two very valuable holdings and very little in actual or potential operating value. Perhaps, she would consider returning all cash to stockholders, reducing the workforce in the company to one person and giving that person a dual-display terminal and let him/her just watch the market value of Alibaba on one and Yahoo Japan on the other. That is my best case scenario and it is unfortunate, but true, that my value per share will move inversely with Ms. Mayer's ambitions.

19 comments:

Anonymous
said...

Dear Professor Damodaran,

I've been reading you for a while, but lord, this is one of the most entertaining pieces you've written. I love the idea of reducing Yahoo! to a single person with a dual display (really splurging there with the two displays, I must say -- activist shareholders may tsk tsk that down to a 13" amber monitor).

I don't own Yahoo! for this exact reason -- I just don't believe that Mayer can use the cash to bring this company back to real value. Maybe paying $1.1 billion for Tumblr will be some sort of a genius move in the future, but I just don't see it.

And Blackberry Club! I love that, too. All those carpel-tunneled thumbs will probably get together for a class action suit.

First possible reason of Yahoo's low valuation as has been mentioned in article related to tax issue in case if Yahoo sell its holding shares in Alibaba and Yahoo Japan. Of course, this scenario is hardly real and Yahoo itself don't want to destroy stakeholder's equity in this way.If talk about Yahoo's core business, I agree that this is "dead" company on advertising field and for instance it should focus its attention as media company. Yahoo previously made some acquisitions and has some background on this business.

For Yahoo, could there be a difference in what the Yahoo investors believe the value of Alibaba should be versus the markets? Given that there is no stated time frame for Yahoo to divest their investments, they would have time for the value to revert to the intrinsic value. This would explain the otherwise negative Yahoo value. If there was a more definite time for your two monitor watcher to call the broker, then we should buy Yahoo and short Alibaba and Yahoo Japan if the short interest payments are less than our realized value from the current negative value. I do; however, agree that this value will most likely not be realized as Mayer bad investments.

I was wondering about this scenario. Yahoo splits itself in two companies, one a holding company with only the Alibaba shares, and one that includes the rest of Yahoo. Yahoo shareholders receive one share in yhoo-baba and one in yhoo-rest for each yhoo share they own.

Then the holding company merges with Alibaba, and yhoo-baba shareholders receive 1 Alibaba share for every 2.6 yhoo-baba share.

Can a split or the merger be subject to capital gains taxes? At no point do the shares get sold.

Presumably there are obvious reasons why this won't fly, but I don't see them, and I'd love to be enlightened.

It's great when you take a look at companies that many of us students interact with. I think some people confuse the axiom "invest in what you know" to mean that its okay to invest in anything that you like.

For example, I know many people who are invested in GoPro since they love their products. I hope you take a look at GPRO and give us a framework on how to think about its valuations. Its up so much I'm afraid to buy it. I also have told others maybe they should sell or hedge some but they tell me I'm crazy and that it could be the next APPL. I'd love to read your thoughts on this.

Dear Prof,If I were Yahoo investor, I would demand the company to distribute Alibaba and YJapan shares among the shareholders. This would impose discipline on management by taking away the 'resources to waste'.Do you reckon it's a viable option and should we expect such demands from activist investors/large institutional shareholders?

Have you thought about hedging the BABA and/or the Yahoo Japan stake for exposure to the stub? Are you comfortable with the risk of BABA dropping wiping out your margin of safety on the valuation arb of Yahoo US?

Just wondering if you had considered the hedged trade, and why you made the decision you did.

I am long the whole YHOO package and see it worth about 50-58 given the public quotes on the holdings and a rough Yahoo US valuation but am obviously concerned about the BABA risk.

On the Apple comment, nice try, but I am not biting, especially since I did buy Apple in the late 1990s and held through 2012. What I am saying is that you should not invest in every dying company, expecting it to pull an "Apple". Apple had Steve Jobs, lots of luck, really bad competition and a technological shift all of which came together in perhaps a once-every-long time phenomenon.On distributing the shares to stockholders, I don't know whether this can be done without triggering taxes at the investor level. My gut says no.On the hedging issue, I have considered it, but I don't plan to be in Yahoo long time and I see the momentum effect dominating fundamentals in $BABA. I may live to regret it, but those are the breaks.

in 1999, Steve jobs was not regarded as a genius, he is seen as a CEO with many flaw. the competitor, msft was seen very strong one at that time, bill gates was still running Microsoft and every college student want to go there instead of investment banks. Today, apple is much weaker without Steve jobs. it's like the microsoft in the Steve ballmer era. so bbry's competition is not strong. in John Chen's last job, he turned around a dying business. I agree with you mostly, but investing is about identifying those cases where things are different. and in the end, people run the business, not numbers.

One thing that you might have missed is the possibility of Yahoo getting bought out.

Consider the following scenarioFacebook buys Yahoo. Facebook gets entry into a new market related to news and publications. This is not where Facebook operates today. Further if Facebook can figure out a way of using the Alibaba cash locally in China (for its own growth) - the tax burden is also reduced.

Trading a high PE FB equityk with a Low PE Yahoo Stock would make FB's revenue go up from $8B to $12B without affecting profitability.

this is exactly the problem with corporate America. The short-term cap gains approach where everybody and their driver acts like a private equity firm. Where companies are no longer made of people but of cash balances and earnings multiples. Even professors from respectable schools get carried away with such nonsense as to suggest firing everyone and keep one guy with a dual monitor. Maybe they should fire you and just keepa cnbc terminal in your classroom

Anonymous,If all I did was repeat what was on CNBC, I would deserve to lose my job and I should. So, your solution to what ails America is that bad businesses be allowed to continue operating with lots of employees. I think Europe is trying that already and how is that working out for them?